ASSET BUBBLES AND BUNGEE CORDS
ASSET BUBBLES AND BUNGEE CORDS
THE SEARCH FOR A BUNGEE CORD MONETARY POLICY
U.S. Federal Reserve Chairman Alan Greenspan has defended the Fed’s actions concerning the Nasdaq price bubble, largely on the basis that to fight the bubble would have required the Fed to send the economy into a major recession. The benefits, if any, of pricking the bubble did not appear to outweigh the costs involved and thus no action was taken. In any case, it was not even clear if there were a bubble. Without such a determination, policy prescriptions are not clear and the danger of economic calamity from incorrect action increases. Under this scenario it made little difference whether the recession came from a burst bubble or Fed policies.
There has been debate as well between the efficient market adherents and the behavioralist wing in economics as to whether this was a rational or irrational event. An examination of the situation shows both Greenspan and the efficient marketers to be correct, although a fuller explanation is required.
There are several aspects to this review. The first is that identification of a bubble is difficult, mostly accomplished in ex poste fashion by witnessing the collapse. How best to deal with them is even less clear since they are so hard to identify. It may be that there are different kinds of asset bubbles, rational and irrational, and that they require different policy approaches to deal with them. It may also be that asset bubbles only become bubbles when they are perceived as such and actions are taken in regard to this perception. They may not be a problem until they are a problem or turned into a problem. Finally, the wisdom of mitigating the impact of asset bubbles and the responses by policy makers need to be fully examined. The proposed response by many observers amounts mostly to a let them have their cake and eat it, too, approach. Let’s have bubbles, but let’s find a way to mitigate the fallout.
Identification of an asset bubble is very difficult, even after the fact. The real question seems to be not so much whether there is an asset bubble, but whether such a bubble holds the possibility of large, negative consequences when it bursts. That determination seems to be dependent upon whether the bubble is viewed as having a rational or irrational basis. Asset bubbles that are viewed as having a rational reason for their existence are viewed as less likely to cause massive dislocations outside the particular economic sector in which they grow when they finally burst. Inside the sector there will be significant fallout, but it will not threaten the stability of the financial system. Asset bubbles that appeared less rational in nature or which infect large areas outside the initial sector are considered far less benignly. Their potential for disruption is greater and more likely to affect many areas of an economy. Such a widespread collapse would engender financial instability and threaten the well-being of the economy.
Rational asset bubbles may best be seen as adventures in valuation pricing, an attempt to place a value on an asset for which there is little historical background. Asset bubbles associated with new technologies may be the best examples of these rational bubbles. In the initial excitement over the promise of new technologies, such as railroads, telephones, or internet, investors may include all benefits from the technology in the prices they are willing to pay and not just those benefits which will accrue to a given investment or stock. The initial price euphoria captures the benefits from externalities as well as the specific benefits that will be given to an investment. Investments as a class are even more likely to reflect this global pricing and become overvalued on the basis of the benefits rightfully flowing from the investments themselves. Since investors are unsure which stocks will benefit in the long run, all get bid up.
Once investors become convinced that the investments will be unable to attain the full benefits implied by the global pricing, the prices collapse and often do not return to the same levels again for a long time, if ever. It is tempting to view these asset bubbles as irrational, and many have done so, but it is more correct to view them as the initial stage in the valuation of a new technology and the initial pricing as rationally including all perceived benefits flowing from that technology. The prices are accurate in that they fully account for the whole potential of societal impact from the new technology. The desire to capture future benefits leads to overinvestment, or more precisely premature investment. Investors see the future stream of benefits, but not always the difficulties in making them a reality. (The same mechanism may be at work when markets overshoot on the upside as well as the downside. Investors overshoot on the upside when trying to price in all the good news by generally bidding up all assets and overshoot on the downside trying to accommodate the bad news by generally bidding down all assets. This will hold true for all levels of the market down to and including individual stocks.)
The roller coaster ride that was Nasdaq is a perfect example of this phenomenon. The euphoria surrounding these stocks built gradually and compounded on itself as the potential of the new technology became more apparent. To be sure, there were other factors for a given stock, such as speculation or day-trading, but as a whole the rise was driven by the vision of the future. The ways in which many of these companies accounted for their futures on their balance sheets reflected this view as well. Once it became clear the future was a long way off and that reaping the profits would be difficult, investors took a closer look. At that point, investors began to question assumptions about future sales and profits and how they were accounted for and the ability of some companies even to survive. Much of this reflection occurred as these companies came back to the markets for a second round of financing and it became clear that they would burn through this capital as well with little to show for the investment. Once the foundations for the prices were eroded, the pyramid collapsed. It is unclear if these prices will ever return to their peak levels.
Asset bubbles that do not stem from new technology are more likely to exhibit irrational pricing behavior and to affect the pricing of other asset classes. The collapse of such a bubble will have more far-reaching negative impacts as a result and tend to cause instability in the financial system. Asset prices in this case do not reflect the global return for an asset, but a belief that the price of the asset will continue to go higher and higher with any price fall in the distant future or of negligible amount. Such bubbles tend to drive up the prices of other asset sectors to raise their return to compete with the now relatively higher returns in the bubble sector. A generalized rise in asset prices results and the collapse of the bubble tends to take all other prices down as well.
The recent rise in Japanese stock and land prices is a good example. Stock prices in Japan rose continually on the view that Japan’s economy was headed for the moon, which in turn caused real estate prices in Japan to follow suit. The bubble was compounded by the use of stocks and real estate as collateral to buy each other, pyramiding the growth in prices to unheard of heights. Capital expenditures financed by the proceeds reinforced the feeling of Japan’s economic invincibility and fed even higher prices. To make matters worse, the asset bubble in Japan spilled over into other regions and into other asset classes such as art and precious stones. Japanese buyers pushed up real estate prices in many foreign countries for both commercial properties and homes, while the Japanese love for art and jewelry led to buying binges in these areas. The collapse of the Japanese Bubble starting in 1990 had an effect in these sectors as well. The Japanese bubble had far-reaching and destabilizing effects that mark it as irrational in nature. (It is conceivable that the bubble could be viewed as pricing in Japan’s future prosperity, but the widespread impact of the bubble outweighs this.)
Another factor that may be at play here, too, is that markets may be asymmetrical in their ability to handle surplus versus scarcity. Markets appear to work quite well when there is scarcity by allocating resources to the investments with the highest returns. It is usually quite clear what these investments are so that the markets allocate the available resources quite efficiently. Such may not be the case when there is a surplus of resources, as we have recently experienced. The available return on investments falls as those with the highest return are invested in first and the ones available have a lower rate of return. Complicating this is that the number of investments at a given level of return rises as the return is lowered, making allocation a more difficult task. Given sufficiently low enough returns, it becomes even less certain which ones are the most desirable to invest in since it is hard to predict actual versus expected returns. This may cause long-term difficulties in an expansion and lead to its collapse.
Investors may then have several reactions. They could invest in all available investments driving up prices across the board since it does not matter which ones are chosen. They could be indiscriminate about which particular ones they invest in since it is unclear which ones will yield the highest return, driving certain assets that become popular to astronomical heights. They may eschew investing in investments with a low return since they are not certain which ones are best and over-invest instead in those areas that have shown a high return. This drives these asset prices far higher and creates an over-investment in capacity in that sector. The root cause in each case is that a surplus causes a change in investment behavior due to the difficulties in identifying the best investments that is not seen in times of deficit.
This reaction raises the question of whether investors invest to maximize return or to receive a given rate of return. The answer may depend on the prevailing circumstances. Low interest rates and a booming economy, such as in the 1990s, may push investors to pursue maximizing returns, which means that they also maximize risk. Investment is distorted and the economy eventually slows. High interest rates in a slow economy may lead to investors setting a given rate of return as their goal since only high return investments can be profitable, but the high risk may be too much in a slowdown. This will lead to underinvestment and keep the economy slow. Low interest rates in a slow economy will likely yield the best allocation of resources with investors seeking to put money into projects that exceed a certain return, while high rates in a booming economy will tend to move investment to the highest uses only.
Even with so obvious an asset bubble as the one in 1980s Japan, however, the question remains what should be done about them, what role is there for monetary authorities in addressing them? Even more to the point, should anything proactive be done or should action be confined to ameliorating the effects of the collapse? While one can easily see the rationale for considering irrational asset bubbles a menace, it is not so clear why a rational bubble escapes this view. Granted, the scale of the collapse is generally smaller and narrower and, therefore, less of a threat, but that does not provide a basis for examining which bubbles should be left alone and which should attract more attention. There is substantial common sense in the view that if an asset bubble is perceived to be forming then monetary and fiscal authorities should move to halt its growth or attempt in some way to manage it. The hope is that by doing so you prevent the hyperinflation of the balloon and its eventual, inevitable collapse. Negative effects are therefore minimized and financial instability is avoided.
There are, though, several caveats to this approach. The first, of course, is identifying whether a bubble exists and then whether it represents an unacceptable risk. Many bubbles are perceived as they form, but others are less obvious and therefore less addressable. It appears that just the initial step of identifying a bubble can prove an inordinately high hurdle to cross since there is still disagreement on whether a bubble preceded the ’29 Crash.
A second problem is determining if we are dealing with a rational or irrational bubble. It may seem straightforward to some – all bubbles are irrational – but that simplistic view is likely to result in bad policy on many occasions. The policy prescriptions will be different for each type of bubble and applying the wrong ones can make matters much worse.
A third problem is deciding whether or not to take steps to address the bubble, rational or irrational, and what steps to take. A simplistic view would be to always say “yes,” we should address the bubble creation because of the problems they create when they burst. Again this shows no differentiation in bubble types, but it also may force action where none is called for.
It may be that no bubble exists until we turn a situation into one. Does a bubble exist in real time or only ex post facto? Does a bubble exist only once it bursts? Before it bursts, it is unclear if the bubble is going to get bigger, burst, or slowly deflate. It may do any of these three of its own accord or as the result of changes in policy. We can, through our actions, turn a potential bubble into a burst bubble with all its consequent effects. A Ponzi scheme may best illustrate this. A Ponzi scheme will work until it no longer works, until there are no more entrants. But until that time, the Ponzi runs smoothly and all is well. Losses can be hastened, though, and their incidence shifted to different entities than would otherwise be the case if shut down prematurely.
This desire to stop a bubble assumes the rightfulness and usefulness of addressing a bubble. It does not take into account that there may be more to be gained by letting bubbles run their course than by cutting them off. The consequences from cutting off a bubble on the downside are more readily apparent, but there may be upside benefits lost as well.
One of the benefits, and perceived negatives, to the bursting of an asset bubble is that it clears out a lot of the weak participants in the sector and redirects investment to the stronger ones and other sectors. This leaves the survivors stronger and better capitalized to move forward once the sector starts to recover from its plunge. Any curtailment of this process will likely lead to fewer participants being weeded out, leaving more competitors fighting for a limited pool of capital, personnel, and business. The recovery may take longer as a result and a second wave of purgings will occur as the weak competitors finally bow out. Curtailing the bubble will not change the outcome, but will stretch it out over a longer period of time and could result in greater losses rather than fewer if the second purge carries out some competitors that would have survived if only one purge happened. It may also lead to greater concentration of the sector than would otherwise have resulted. Who survives will change as well. Japan may be a prime example of this outcome, suffering a decade-long stagnation because the process was short-circuited.
Cutting short a bubble may have long-term negative consequences for the competitiveness of the sector by failing to attract the right competitors to the market. It appears to be assumed that those who arrive early to the bubble and those who arrive when it is still not in hyperinflation fare the best in the long run. Those who arrive at the end of the cycle are felt to be the weakest, least capitalized competitors and basically serve as fodder for the bubble’s growth. It is not clear, though, which group of competitors fares best in the long run and by keeping out the late-comers we may be denying some of the best competitors their shot at success. Some large, deep pocket players may not arrive until late in the game as well after surveying the sector for the best entry point. Even if it turns out that they who come last to the party are the worst dancers, they may still fill a vital role in the creation and destruction processes that will go unfilled and reduce the competitiveness of the sector. We create winners and losers in this way who might not have filled those roles otherwise.
Slowing the bubble may also slow down adoption of new technology and slow its pace of innovation. The bubble is created by the rush of new entrants and financiers to the sector, and that creates its own momentum for adoption of the new technology while increasing the rate of innovation. If the bubble is cut short, the technology may not achieve a critical mass needed to bring forth the best variant of a technology and result in a less innovative change than it would otherwise.
The stated reason for addressing an asset bubble is to minimize the fallout from the bubbles and to avoid any financial instability they can cause. What seems to be unstated is that we should really be trying to enjoy the benefits of the bubble and avoid its costs. Part of the attractiveness of creating a bubble is the thrill of the ride. It is akin to the thrill of a freefall jump, it’s just that sudden stop at the end that’s the problem. Through the wonders of technology and ingenuity, we can now experience the thrill of the freefall, yet avoid that nasty stop at the end. Bungee cords, quite literally, allow us to experience the thrills of a fall and live, not only to tell about them, but to do it again.
It appears that this is what many are seeking when they argue for intervention to address asset bubbles. They want to enjoy the ride and benefits of the bubble, they just don’t want to pay the price at the end. They’re looking for a bungee cord monetary policy that will allow us to enjoy the trip and not fear the landing since there is none. Just when disaster approaches, the cord snaps us back and saves the day. We are relieved, but thrilled. Let’s do it again.
Greenspan is correct when he states the Fed did the right thing by not popping the Nasdaq bubble. It is painful for those who have gone through the process, but any action would have just shifted the incidence of the pain and prolonged it. He is right, too, because the bubble had a rational basis and short-circuiting its run would have lead to inefficiency and stunted innovation. There is no doubt that there has been a great deal of pain brought about by this collapse and that many are looking for a way to stop the pain next time. To do so, however, will leave our economy more not less vulnerable.
THE SEARCH FOR A BUNGEE CORD MONETARY POLICY
U.S. Federal Reserve Chairman Alan Greenspan has defended the Fed’s actions concerning the Nasdaq price bubble, largely on the basis that to fight the bubble would have required the Fed to send the economy into a major recession. The benefits, if any, of pricking the bubble did not appear to outweigh the costs involved and thus no action was taken. In any case, it was not even clear if there were a bubble. Without such a determination, policy prescriptions are not clear and the danger of economic calamity from incorrect action increases. Under this scenario it made little difference whether the recession came from a burst bubble or Fed policies.
There has been debate as well between the efficient market adherents and the behavioralist wing in economics as to whether this was a rational or irrational event. An examination of the situation shows both Greenspan and the efficient marketers to be correct, although a fuller explanation is required.
There are several aspects to this review. The first is that identification of a bubble is difficult, mostly accomplished in ex poste fashion by witnessing the collapse. How best to deal with them is even less clear since they are so hard to identify. It may be that there are different kinds of asset bubbles, rational and irrational, and that they require different policy approaches to deal with them. It may also be that asset bubbles only become bubbles when they are perceived as such and actions are taken in regard to this perception. They may not be a problem until they are a problem or turned into a problem. Finally, the wisdom of mitigating the impact of asset bubbles and the responses by policy makers need to be fully examined. The proposed response by many observers amounts mostly to a let them have their cake and eat it, too, approach. Let’s have bubbles, but let’s find a way to mitigate the fallout.
Identification of an asset bubble is very difficult, even after the fact. The real question seems to be not so much whether there is an asset bubble, but whether such a bubble holds the possibility of large, negative consequences when it bursts. That determination seems to be dependent upon whether the bubble is viewed as having a rational or irrational basis. Asset bubbles that are viewed as having a rational reason for their existence are viewed as less likely to cause massive dislocations outside the particular economic sector in which they grow when they finally burst. Inside the sector there will be significant fallout, but it will not threaten the stability of the financial system. Asset bubbles that appeared less rational in nature or which infect large areas outside the initial sector are considered far less benignly. Their potential for disruption is greater and more likely to affect many areas of an economy. Such a widespread collapse would engender financial instability and threaten the well-being of the economy.
Rational asset bubbles may best be seen as adventures in valuation pricing, an attempt to place a value on an asset for which there is little historical background. Asset bubbles associated with new technologies may be the best examples of these rational bubbles. In the initial excitement over the promise of new technologies, such as railroads, telephones, or internet, investors may include all benefits from the technology in the prices they are willing to pay and not just those benefits which will accrue to a given investment or stock. The initial price euphoria captures the benefits from externalities as well as the specific benefits that will be given to an investment. Investments as a class are even more likely to reflect this global pricing and become overvalued on the basis of the benefits rightfully flowing from the investments themselves. Since investors are unsure which stocks will benefit in the long run, all get bid up.
Once investors become convinced that the investments will be unable to attain the full benefits implied by the global pricing, the prices collapse and often do not return to the same levels again for a long time, if ever. It is tempting to view these asset bubbles as irrational, and many have done so, but it is more correct to view them as the initial stage in the valuation of a new technology and the initial pricing as rationally including all perceived benefits flowing from that technology. The prices are accurate in that they fully account for the whole potential of societal impact from the new technology. The desire to capture future benefits leads to overinvestment, or more precisely premature investment. Investors see the future stream of benefits, but not always the difficulties in making them a reality. (The same mechanism may be at work when markets overshoot on the upside as well as the downside. Investors overshoot on the upside when trying to price in all the good news by generally bidding up all assets and overshoot on the downside trying to accommodate the bad news by generally bidding down all assets. This will hold true for all levels of the market down to and including individual stocks.)
The roller coaster ride that was Nasdaq is a perfect example of this phenomenon. The euphoria surrounding these stocks built gradually and compounded on itself as the potential of the new technology became more apparent. To be sure, there were other factors for a given stock, such as speculation or day-trading, but as a whole the rise was driven by the vision of the future. The ways in which many of these companies accounted for their futures on their balance sheets reflected this view as well. Once it became clear the future was a long way off and that reaping the profits would be difficult, investors took a closer look. At that point, investors began to question assumptions about future sales and profits and how they were accounted for and the ability of some companies even to survive. Much of this reflection occurred as these companies came back to the markets for a second round of financing and it became clear that they would burn through this capital as well with little to show for the investment. Once the foundations for the prices were eroded, the pyramid collapsed. It is unclear if these prices will ever return to their peak levels.
Asset bubbles that do not stem from new technology are more likely to exhibit irrational pricing behavior and to affect the pricing of other asset classes. The collapse of such a bubble will have more far-reaching negative impacts as a result and tend to cause instability in the financial system. Asset prices in this case do not reflect the global return for an asset, but a belief that the price of the asset will continue to go higher and higher with any price fall in the distant future or of negligible amount. Such bubbles tend to drive up the prices of other asset sectors to raise their return to compete with the now relatively higher returns in the bubble sector. A generalized rise in asset prices results and the collapse of the bubble tends to take all other prices down as well.
The recent rise in Japanese stock and land prices is a good example. Stock prices in Japan rose continually on the view that Japan’s economy was headed for the moon, which in turn caused real estate prices in Japan to follow suit. The bubble was compounded by the use of stocks and real estate as collateral to buy each other, pyramiding the growth in prices to unheard of heights. Capital expenditures financed by the proceeds reinforced the feeling of Japan’s economic invincibility and fed even higher prices. To make matters worse, the asset bubble in Japan spilled over into other regions and into other asset classes such as art and precious stones. Japanese buyers pushed up real estate prices in many foreign countries for both commercial properties and homes, while the Japanese love for art and jewelry led to buying binges in these areas. The collapse of the Japanese Bubble starting in 1990 had an effect in these sectors as well. The Japanese bubble had far-reaching and destabilizing effects that mark it as irrational in nature. (It is conceivable that the bubble could be viewed as pricing in Japan’s future prosperity, but the widespread impact of the bubble outweighs this.)
Another factor that may be at play here, too, is that markets may be asymmetrical in their ability to handle surplus versus scarcity. Markets appear to work quite well when there is scarcity by allocating resources to the investments with the highest returns. It is usually quite clear what these investments are so that the markets allocate the available resources quite efficiently. Such may not be the case when there is a surplus of resources, as we have recently experienced. The available return on investments falls as those with the highest return are invested in first and the ones available have a lower rate of return. Complicating this is that the number of investments at a given level of return rises as the return is lowered, making allocation a more difficult task. Given sufficiently low enough returns, it becomes even less certain which ones are the most desirable to invest in since it is hard to predict actual versus expected returns. This may cause long-term difficulties in an expansion and lead to its collapse.
Investors may then have several reactions. They could invest in all available investments driving up prices across the board since it does not matter which ones are chosen. They could be indiscriminate about which particular ones they invest in since it is unclear which ones will yield the highest return, driving certain assets that become popular to astronomical heights. They may eschew investing in investments with a low return since they are not certain which ones are best and over-invest instead in those areas that have shown a high return. This drives these asset prices far higher and creates an over-investment in capacity in that sector. The root cause in each case is that a surplus causes a change in investment behavior due to the difficulties in identifying the best investments that is not seen in times of deficit.
This reaction raises the question of whether investors invest to maximize return or to receive a given rate of return. The answer may depend on the prevailing circumstances. Low interest rates and a booming economy, such as in the 1990s, may push investors to pursue maximizing returns, which means that they also maximize risk. Investment is distorted and the economy eventually slows. High interest rates in a slow economy may lead to investors setting a given rate of return as their goal since only high return investments can be profitable, but the high risk may be too much in a slowdown. This will lead to underinvestment and keep the economy slow. Low interest rates in a slow economy will likely yield the best allocation of resources with investors seeking to put money into projects that exceed a certain return, while high rates in a booming economy will tend to move investment to the highest uses only.
Even with so obvious an asset bubble as the one in 1980s Japan, however, the question remains what should be done about them, what role is there for monetary authorities in addressing them? Even more to the point, should anything proactive be done or should action be confined to ameliorating the effects of the collapse? While one can easily see the rationale for considering irrational asset bubbles a menace, it is not so clear why a rational bubble escapes this view. Granted, the scale of the collapse is generally smaller and narrower and, therefore, less of a threat, but that does not provide a basis for examining which bubbles should be left alone and which should attract more attention. There is substantial common sense in the view that if an asset bubble is perceived to be forming then monetary and fiscal authorities should move to halt its growth or attempt in some way to manage it. The hope is that by doing so you prevent the hyperinflation of the balloon and its eventual, inevitable collapse. Negative effects are therefore minimized and financial instability is avoided.
There are, though, several caveats to this approach. The first, of course, is identifying whether a bubble exists and then whether it represents an unacceptable risk. Many bubbles are perceived as they form, but others are less obvious and therefore less addressable. It appears that just the initial step of identifying a bubble can prove an inordinately high hurdle to cross since there is still disagreement on whether a bubble preceded the ’29 Crash.
A second problem is determining if we are dealing with a rational or irrational bubble. It may seem straightforward to some – all bubbles are irrational – but that simplistic view is likely to result in bad policy on many occasions. The policy prescriptions will be different for each type of bubble and applying the wrong ones can make matters much worse.
A third problem is deciding whether or not to take steps to address the bubble, rational or irrational, and what steps to take. A simplistic view would be to always say “yes,” we should address the bubble creation because of the problems they create when they burst. Again this shows no differentiation in bubble types, but it also may force action where none is called for.
It may be that no bubble exists until we turn a situation into one. Does a bubble exist in real time or only ex post facto? Does a bubble exist only once it bursts? Before it bursts, it is unclear if the bubble is going to get bigger, burst, or slowly deflate. It may do any of these three of its own accord or as the result of changes in policy. We can, through our actions, turn a potential bubble into a burst bubble with all its consequent effects. A Ponzi scheme may best illustrate this. A Ponzi scheme will work until it no longer works, until there are no more entrants. But until that time, the Ponzi runs smoothly and all is well. Losses can be hastened, though, and their incidence shifted to different entities than would otherwise be the case if shut down prematurely.
This desire to stop a bubble assumes the rightfulness and usefulness of addressing a bubble. It does not take into account that there may be more to be gained by letting bubbles run their course than by cutting them off. The consequences from cutting off a bubble on the downside are more readily apparent, but there may be upside benefits lost as well.
One of the benefits, and perceived negatives, to the bursting of an asset bubble is that it clears out a lot of the weak participants in the sector and redirects investment to the stronger ones and other sectors. This leaves the survivors stronger and better capitalized to move forward once the sector starts to recover from its plunge. Any curtailment of this process will likely lead to fewer participants being weeded out, leaving more competitors fighting for a limited pool of capital, personnel, and business. The recovery may take longer as a result and a second wave of purgings will occur as the weak competitors finally bow out. Curtailing the bubble will not change the outcome, but will stretch it out over a longer period of time and could result in greater losses rather than fewer if the second purge carries out some competitors that would have survived if only one purge happened. It may also lead to greater concentration of the sector than would otherwise have resulted. Who survives will change as well. Japan may be a prime example of this outcome, suffering a decade-long stagnation because the process was short-circuited.
Cutting short a bubble may have long-term negative consequences for the competitiveness of the sector by failing to attract the right competitors to the market. It appears to be assumed that those who arrive early to the bubble and those who arrive when it is still not in hyperinflation fare the best in the long run. Those who arrive at the end of the cycle are felt to be the weakest, least capitalized competitors and basically serve as fodder for the bubble’s growth. It is not clear, though, which group of competitors fares best in the long run and by keeping out the late-comers we may be denying some of the best competitors their shot at success. Some large, deep pocket players may not arrive until late in the game as well after surveying the sector for the best entry point. Even if it turns out that they who come last to the party are the worst dancers, they may still fill a vital role in the creation and destruction processes that will go unfilled and reduce the competitiveness of the sector. We create winners and losers in this way who might not have filled those roles otherwise.
Slowing the bubble may also slow down adoption of new technology and slow its pace of innovation. The bubble is created by the rush of new entrants and financiers to the sector, and that creates its own momentum for adoption of the new technology while increasing the rate of innovation. If the bubble is cut short, the technology may not achieve a critical mass needed to bring forth the best variant of a technology and result in a less innovative change than it would otherwise.
The stated reason for addressing an asset bubble is to minimize the fallout from the bubbles and to avoid any financial instability they can cause. What seems to be unstated is that we should really be trying to enjoy the benefits of the bubble and avoid its costs. Part of the attractiveness of creating a bubble is the thrill of the ride. It is akin to the thrill of a freefall jump, it’s just that sudden stop at the end that’s the problem. Through the wonders of technology and ingenuity, we can now experience the thrill of the freefall, yet avoid that nasty stop at the end. Bungee cords, quite literally, allow us to experience the thrills of a fall and live, not only to tell about them, but to do it again.
It appears that this is what many are seeking when they argue for intervention to address asset bubbles. They want to enjoy the ride and benefits of the bubble, they just don’t want to pay the price at the end. They’re looking for a bungee cord monetary policy that will allow us to enjoy the trip and not fear the landing since there is none. Just when disaster approaches, the cord snaps us back and saves the day. We are relieved, but thrilled. Let’s do it again.
Greenspan is correct when he states the Fed did the right thing by not popping the Nasdaq bubble. It is painful for those who have gone through the process, but any action would have just shifted the incidence of the pain and prolonged it. He is right, too, because the bubble had a rational basis and short-circuiting its run would have lead to inefficiency and stunted innovation. There is no doubt that there has been a great deal of pain brought about by this collapse and that many are looking for a way to stop the pain next time. To do so, however, will leave our economy more not less vulnerable.
posted by BNitemoves at 6:02 PM
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